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European Union Faces Crucial Test in Brexit Referendum

Investment Insights

June 2016

European Union Faces Crucial Test in Brexit Referendum

U.K. voters will go to the polls on Thursday, June 23 to decide whether they should stay in the European Union or abandon the 28-nation bloc. The so-called Brexit vote is a significant challenge to the EU’s authority and threatens to further destabilize Europe at a time when weak economic growth and high debt levels are already straining intergovernmental relations.

Brexit opponents argue that leaving the EU would trigger an economic catastrophe by voiding trade agreements and other measures that allow the free flow of capital and people throughout Europe. Brexit supporters say the U.K. has essentially given up its sovereignty to the EU and no longer has enough control over its own laws. Immigration policy, in particular, has been at the center of the debate.

Recent polls show that Brexit support is on the rise, but the outcome remains in doubt and the uncertainty is expected to fuel near-term market volatility. That is especially true in the currency market — the pound sterling has declined sharply at times amid fears of a messy U.K. departure. According to several recent polls, the margin between “remain” and “leave” is tight and there are many “undecided” voters in the mix.

“Traditionally in referendums, there is a ‘status-quo bias’ because undecided voters tend to favor certainty,” says Talha Khan, a political economist based in our London office. “While that will most likely hold true in this referendum, the result may ultimately hinge on voter turnout. The higher the turnout, the more likely the ‘remain’ campaign will prevail. If the turnout is low, then the more emotional ‘leave’ campaign could deliver a shock outcome.”

Political and Investment Implications

In the event that Britain decides to leave the European Union, uncertainty would reign in the political arena and financial markets, likely hurting key areas of the economy such as business investment, consumer confidence, the currency and foreign direct-investment flows. Moreover, the withdrawal of a large, established member from the EU has never been tested before so there is no roadmap to follow.

A formal exit could take at least two years to complete, and there may be little change to the U.K.’s formal relations with the EU during that period. Adjustments would have to be made to trade policies, immigration laws and financial regulations, among other issues. Restructuring relationships between close political and economic partners is likely to be a challenge due to the intricacy of existing agreements and the importance of maintaining strong ties for all parties involved.

During the negotiation period and beyond, the impact on the U.K. economy and investments could be significant. Already, on a year-to-date basis, the pound has fallen nearly 6% against the euro and about 2% against the U.S. dollar. Although the U.K. is a member of the European Union, it has never adopted the euro as its currency.

“It is hard not to expect further sterling weakness if Brexit were to materialize,” says Philip Chitty, a London-based sovereign debt analyst with Capital Group. “At the same time, the U.K.’s rising current account deficit is another reason to expect sterling to be weaker over the medium term.”

Economic Downturn Expected

Stock prices in the U.K. and the broader European market may also suffer. European stocks have come under pressure in recent months amid concerns about anemic economic growth, deflationary conditions and negative interest rates in some euro-zone countries. However, U.K. stocks have generated significantly better returns on a year-to-date basis, compared to the wider MSCI Europe Index.

“If Britain were to leave the EU, the next two years would be riddled with concern over bilateral trade and visa negotiations,” says equity analyst Natasha Braginsky Mounier. “Neither markets nor families do well under such conditions, so this would probably cause a downturn in spending, home prices and, naturally, equity markets.”

Indeed, British Prime Minister David Cameron said Brexit would devastate the U.K. economy. Under a conservative analysis, the U.K. Treasury has estimated that leaving the EU would trigger a recession in the year following the vote and unemployment would rise by about 520,000. Additionally, the Treasury analysis predicted that Britain’s gross domestic product would fall by about 3.6% after two years and home prices would be roughly 10% lower compared to estimated price levels if the U.K. remained within the EU confines.

Global Impact

The International Monetary Fund has warned that a British withdrawal could derail global economic growth, as well. The IMF has already cut this year’s growth forecast for the U.K. economy to 1.9% from its previous forecast of 2.2% on an annualized basis. Brexit supporters, including former London Mayor Boris Johnson, have challenged the accuracy of the U.K. Treasury and IMF numbers, arguing that Britain would benefit from having greater control over its laws and limiting the flow of migrants from other countries.

Meanwhile, the City of London’s status as a global financial center could be diminished by a U.K. exit as well. London is currently home to more than 200 international banks that are attracted to the U.K., in part, by the ability to conduct business seamlessly throughout the European Union. Some of these banks may decide to relocate outside the U.K., taking well-paying jobs with them.

Outside the U.K., European banks in general are another area of concern. Bank earnings likely would be hurt by any sort of economic slowdown. Italian, Portuguese and Spanish banks probably would be the most vulnerable, given the fragile economies where they do business. European bank stocks have already declined sharply in recent months amid negative interest rates in the euro zone and weak economic growth throughout the region.

Shelter From the Storm?

While many asset prices could be hurt under a Brexit scenario, high-grade government bonds would likely benefit from a flight-to-safety trend, notes Mark Brett, a fixed income portfolio manager with Capital Group. Those would include U.K. gilts, German bunds and U.S. Treasuries — classic safe-haven assets.

British and German bonds have rallied strongly in the weeks leading up to the vote. While the referendum may be partially fueling this rally, it is also likely a result of an aggressive bond-buying program launched by the European Central Bank. In the days leading up to the June 23 vote, elevated volatility is likely, Mark adds.

“If Brexit does happen, it will provide a short-term shock to the euro zone, with companies delaying capital expenditure and hiring yet again,” Mark says. “Therefore, I am seeking out relatively safer investment options in areas that would be less affected by the departure.”

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